March 10, 2006,
The best way for the federal government to foster innovation, economic growth, and U.S. global competitiveness is to stop taxing capital gains. While the current debate in Washington centers on whether the capital-gains rate should stay at 15 percent or increase to 20 percent in 2008, I contend that the best rate is zero.
According to the American Council for Capital Formation, our current 15 percent individual capital-gains tax rate puts us in the middle of the pack within the OECD (the Organization for Economic Cooperation and Development). In fact, fourteen of thirty OECD countries do not tax individual capital gains at all. China an emerging economic powerhouse exempts domestic investors from the capital-gains tax and recently extended that exemption to foreigners. Similarly, the U.S. corporate capital-gains tax of 35 percent is far higher than the 23 percent average of our OECD competitors.
Our punitive capital-gains tax burdens our global competitiveness. First, it produces a “lock-in” effect, discouraging both individual and corporate taxpayers from selling capital assets and realizing capital gains because of the high tax costs. This prevents hundreds of billions of dollars in capital from flowing to its most efficient and productive uses. As President John F. Kennedy put it in 1963, “The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital … the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential growth in the economy.”
Second, the capital-gains tax is a “double tax” that encourages firms to finance expansion by taking on more debt rather than selling capital and financial assets. Here’s what happens: With the capital-gains tax in place, income is first taxed at the corporate level and then again at the individual level when shareholders sell their corporate stock. By contrast, because interest expenses are tax deductible, debt-financing is taxed only once. So businesses borrow against their existing assets instead of selling assets, which undermines the financial stability and flexibility of many companies.
The capital-gains tax impedes business creation and entrepreneurship. History shows that the amount of seed-capital funding available to fledgling start-ups is highly sensitive to changes in the capital-gains tax. For example, when the top capital-gains tax was slashed from 49 percent in 1977 to 20 percent in 1983, the amount of venture-capital funding for new firms increased from $68 million to $5.1 billion a 700 percent increase. Conversely, when the capital-gains rate was raised to 28 percent, venture-capital funding fell by almost 60 percent (between 1986 and 1991).
Furthermore, start-ups depend heavily on equity investments by individuals friends, family, and other informal sources who are sensitive to the level of the capital-gains tax. In a survey of 284 new companies undertaken in the late 1980s, professors William Wetzel and John Freear of the University of New Hampshire found taxable individuals to be the major source of funds for those start-up firms, raising $500,000 or less at a time. A high capital-gains tax rate would certainly discourage equity investments by individuals.
By promoting economic growth, a zero capital-gains tax would over time produce additional tax revenue. As former Federal Reserve chairman Alan Greenspan once explained, “If the capital gains tax were eliminated … we would presumably, over time, see increased economic growth which would raise revenues for personal and corporate taxes as well as other taxes that we have. … [The] major impact [of a capital-gains tax], as best I can judge, is to impede entrepreneurial activity and capital formation. ... I [have] argued that the appropriate capital gains tax rate [is] zero.”
A recent Pew Research public opinion poll found that Democrats now enjoy an 11 point advantage over Republicans on the issue of which party would do a better job of handling the economy. To regain the economic and political offensive, Republicans must propose a bold policy agenda to boost economic opportunity, entrepreneurship, and competitiveness. Abolishing the capital-gains tax is an idea that would appeal to the investor-class voters who make up a growing portion of the American electorate while providing immediate economic benefits by boosting the stock market and unlocking billions of dollars of investment capital.
Cesar Conda, a former assistant for domestic policy under Vice President Dick Cheney, is a senior fellow at Freedom Works.